Mutual Fund Trusts
The following is a general overview of taxation matters
applicable to Mutual Fund Trusts. This information was considered
accurate at the time it was published and is subject to change at
anytime. Please speak with your financial or tax planner about
matters of taxation applicable to you.
Why do we have year-end distributions?
Any income earned during the year by mutual fund trusts must be
paid out to its unitholders or the fund risks paying tax on this
income, which it is not permitted to do. This is consistent with
the idea that economic consequences pass from the mutual fund to
investors. Only unitholdersof the funds on the distribution record
date will receive a distribution.
How are distributions taxed?
Mutual funds primarily earn interest income, dividend income,
foreign-sourced income and capital gains. Each of these types of
income is taxed differently. The various types of income earned by
the mutual fund retain their "character" when distributed to
unitholders - interest income in the fund is interest income in the
hands of the unitholder. Generally, the unitholder will pay taxes
from a lower tax bracket than the fund would should it be directly
responsible for paying tax on its income.
The following summarizes the various types of income generally
distributed from a mutual fund trust:
-Interest income is the income earned
on fund holdings such as T-bills and bonds. It is categorized as
"other income" on T3 slips. This type of income is 100% taxable at
the unitholders' marginal tax rate.
-Dividends from Canadian corporations
are subject to the 25% gross-up and tax credit mechanism. Canadian
dividends attract the lowest rate of tax.
-Foreign-sourced income includes both
interest and dividends from outside Canada. This income is reported
in Canadian dollars, gross of any foreign taxes paid. It is subject
to the same rate of tax as interest income, although foreign taxes
paid may be claimed as a tax credit.
-Capital gains are generated upon the
sale of securities by the mutual fund which have increased in value
over their acquisition cost. Unrealized gains are
not taxable. The fund will distribute the
entire capital gain, although only 50% is reported as income and
taxable at the unitholder's marginal tax rate.
Does it matter how long I hold my mutual fund units?
The answer is no. As long as the units are owned on the
distribution record date, even if they were purchased the day
before, the unitholder will receive a distribution.
What is a return of capital?
If a fund distributes more than the income, dividends and
capital gains earned in the year, the excess is a return of
capital. This return of capital is not taxable, although it reduces
the adjusted cost base of the unitholders' investments. By reducing
the cost base, the unitholders' potential capital gain will be
larger if they sell their units. If the cost base is reduced to
zero, capital gains will apply to any amounts below zero.
What are the consequences of receiving a distribution in the
form of units?
The income distributed is taxable whether it is paid in cash or
reinvested in the fund. A distribution in the form of units will
encourage compound returns; however, it does not provide cash to
pay the resulting tax liability. In addition, the cost base of your
client's investment will be impacted by the value of the units
Why is 'adjusted cost base" relevant?
The adjusted cost base of the units is important. It is used
when calculating the capital gain or loss resulting upon the sale
The comments in this Tax Tip are not intended, nor should they
be relied upon, to replace specific professional advice.